IHG is a success, and that changes everything in the hardware market for small independent retailers

HNN Sources

The hardware retail industry has underestimated the extent to which the acquisition of the Home Timber & Hardware Group (HTH) by Metcash would change the hardware retail market. Rather than being a footnote, just a shifting around of the existing players, it has instead unleashed new competitive forces.

Overall, we could say that prior to the failure of Woolworths' Masters Home Improvement venture at the end of 2016, the hardware retail market was divided into two, or, at most, two-and-a-half sectors. Today, it has become clearly divided into three sectors. All three are now in competition with each other.

In addition, strategic changes at Bunnings, accelerated by shifts in the overall strategy of its parent corporation, Wesfarmers, will also add to these new competitive pressures.

This means that buying groups for independent hardware retailers outside of IHG will need to rethink their strategies, and their management metrics. What strategies will work in this new competitive environment, and what metrics should they be supported by?

Changing roles

Fundamental to these questions is the consideration of what the real role of the buying group will be for hardware retailers in the future. Up until the present day, the primary focus of buying groups has been, understandably, on helping member retailers obtain reasonable wholesale prices and rebates on a wide range of products.

While that will obviously be an ongoing, and very important role, we need to consider whether these buying groups need to consider expanding on what they do offer members. Now that there are two players in the market, Bunnings and IHG, which place a competitive premium on driving down prices ever lower by leveraging volume, other retailers participating in the market may need to consider further leveraging the advantages they have outside of price, in order to retain both their marketshare, and reasonable margins on the products they sell.

Most independent retailers see one of their prime market advantages as being their close working relationships with tradies and building businesses. Could it be that in the future buying groups need to also concentrate on helping their members enhance that aspect of their businesses?

Background

In order to trace how the hardware retail market has changed, it's necessary to consider how it has developed over the past 25 years.

After its full acquisition by Metcash in 2012, up until 2017, Mitre 10 represented one alternative path for independent store owners to take. The CEO of Mitre 10 (and now of IHG), Mark Laidlaw, worked quite hard in public speeches during that time to suggest that Bunnings was something of an endlessly accretive force aimed at "gobbling up" as much marketshare as possible. He presented Mitre 10 as offering something of a shield from that, and many independent retailers were grateful to accept what seemed at least a safer harbour in the market.

We could say that during this time the independent sector, outside of Bunnings, had something of a "soft line" between the Mitre 10 and HTH businesses, both of which were corporate-owned, and the rest of the independents. Mitre 10 certainly wanted to coax more independent stores to join the group. That competitive drive, however, was balanced by the near-equal market share of HTH. HTH also had very strong corporate backing from Woolworths, with its massive investment in Masters. This limited the extent of competitive actions by Mitre 10.

With the acquisition by Metcash of HTH in late 2016, competitive actions by IHG were directed largely to self-preservation, especially in discouraging either Mitre 10 or HTH stores from leaving the network in the wake of the amalgamation of the two. One aspect of that shift was that the company's public statements as regards competition with Bunnings shifted from providing a safe harbour, to IHG being able to "take it to Bunnings". IHG suggested, in comments repeated in the mainstream press, that its $2.1 billion in annual revenue somehow compared to the $13.6 billion of Bunnings.

Overall, IHG's actions to retain stores have been successful, with relatively few leaving, even after the announcement that the Home brand would eventually become secondary to the Mitre 10 brand in 2020. Publicly Mr Laidlaw has stated that IHG has lost only a few smaller stores to the Hardware & Building Traders (HBT) group, as of the end of the first half for its FY2017/18.

Perhaps encouraged by that success, by late 2017 there began to emerge moves by IHG to compete more directly with other independents. This went beyond encouraging more stores to join IHG. Instead, it shifted to taking marketshare away from stores in the independent sector.

Take, for example, the recent dustup between Natbuild and IHG regarding allegations of unauthorised access to a database of trade agreements made between the former and its suppliers. This could be taken as a clear sign of a change in competitive strategy at IHG. While there has never been any suggestion in these allegations that this was part of a formal strategy by IHG, in HNN's opinion the allegations portrayed the actions of not just one or two "rogue" individuals, but showed a wider (though limited) involvement. Those allegations (if they were factual) indicate a degree of independent-on-independent competition that is completely new to the market. (We note that, according to industry sources, a settlement has been made in this case.)

From this we can see that the independent market, after the consolidation of the market power of HTH and Mitre 10 into a single entity, has fractured into two distinct, competing parts. This split market operates alongside the existing competition with Bunnings.

In FY2018/19 Bunnings, with the divestment of Coles by its parent company Wesfarmers, and the cessation of its UK-based expansion, will likely be stepping up its competitive pressure in the Australia hardware market.

This combination of factors means that as we move into FY2018/19, the overall hardware retail industry is facing a very different competitive situation from that of the previous six or seven years.

IHG and critical mass

While this is the overall picture, its effects on individual store retailers remain muted, so far. Most of the retailers in IHG might compete avidly with nearby stores from other buying groups - but no more avidly than they would with stores from IHG that are also located in their immediate geographic market area.

In general, all independent retailers see themselves as sharing a great many values and vulnerabilities with most other independent stores, from all buying groups. Some of that unification is an indirect result of having to constantly deal with highly effective competition from Bunnings over the past eight years.

The reason why store-on-store competition is not noticeable just yet is that the real competitive arena is currently at the supplychain level. Each sector of the current market has its own supplychain strategies. While these have broad similarities, they also have important differences, and carry varying strategic consequences.

The Bunnings strategy is very sophisticated, and makes complex use of captive brands and, in the case of certain suppliers, what we might even term captured brands (Irwin being an example of the latter). This is a supply (rather than purchasing) strategy, in that it reaches all the way back to the manufacturing process for many products. It is this strategy that in many ways is responsible for creating the market conditions under which the entire market operates.

The IHG strategy is simpler, and borrows heavily from the Mitre 10 strategy, which was in turn largely modelled on the overall strategy of Metcash's wholesale food businesses. In that strategy, a system of distribution (as opposed to storage) warehouses is central to a buying system that seeks to purchase goods in bulk, then distributes these directly to member stores. This model is aimed at creating highly efficient purchasing, such that IHG can pressure suppliers into ever-lower prices, creating - in theory - wider profit margins and/or higher sales volume through lower prices.

Key to the success of this strategy for a wholesaler such as IHG, which has a far from dominant position in the market, is the consolidation of demand. The fewer suppliers it contracts with, and thus the higher the volume for each of its product lines, the more pressure it is able to exert on suppliers, and the better the deal it will be able to obtain.

Yet, as the majority of the stores in its retail network are independently owned, it cannot overtly control what is sold. It can, however, exert some influence through, for example, requiring that stores stock items marketed through a print mail catalogue, or promoted on TV and radio. Incentives, such as the Sapphire store program, can also help to impose narrower choices by placing constraints on retailers.

Ultimately, of course, if all goes according to plan, and IHG is able to reach a kind of critical mass of order consolidation, the lower prices on its approved product lines will be so attractive that stores will have little inclination to order anything outside of them. This creates a circular relationship were lower prices drive concentrated demand, and concentrated demand further drives lower prices.

Both Bunnings and IHG seek to use scale to obtain lower prices. The scale (order volume) that Bunnings provides across several lines of goods is enough to facilitate manufacturing economies, as typically the production cost-per-unit drops as volume increases. That applies less frequently to the level of scale that IHG provides. Both, however, can provide scale benefits that reduce distribution costs, especially for imported goods. And, of course, through guaranteed forward order volumes, both substantially reduce risk for suppliers, which, in a very fragmented market, has considerable value.

Independents and scale

In the third sector, outside Bunnings and IHG, made up of small independent buying groups, strategies have until recently been much simpler. Several of these groups were formed as something of a "rebellion" in the late 1990s against what were seen as restrictive and unprofitable requirements by the Danks and Mitre 10 management of the time. Their goal back then was to bring together retailers into groups which could better negotiate with suppliers to get sharper deals on supply price and rebates than retailers could manage on their own.

As these groups have grown in terms of size and complexity, their strategies have shifted. There are, at the moment, really two main aspects to these strategies.

One of their most important developments (from the perspective of the overall health of the market) has been the introduction and support of comparatively new brands and suppliers. As many of these brands are, to some extent, excluded from dealing with Bunnings and/or IHG, or have only a minor presence in those retailers, they are eager to cultivate alternative distribution.

Doing deals with these brands provides the buying groups with two key advantages: lower prices and better rebates, as well as a clear point of differentiation from larger retailers and retail groups.

The second part of the strategies has to do with scale. However, scale for the smaller buying groups behaves differently that it does for the other two market sectors.

Over the past two years, these buying groups have begun to follow IHG somewhat in terms of trying to concentrate orders through an elevated group of suppliers, so as to increase volume, and create further opportunities for better margins and/or larger rebates. While this does certainly make sense, and does deliver definite benefits in some areas, it may be a case of pursuing a smaller advantage at the cost of a greater one.

To uncover some of the potentially greater benefits in the market, it is necessary to look at:

what the goals of independents are in terms of pricing strategies,

the types of suppliers they deal with and how potential scale affects each of these, and

how the division of the independent market into two discrete sectors has changed the situation.

Pricing and market goals for independents

In analysing pricing strategies it is almost impossible to start anywhere other than the influence of Bunnings on the market. Bunnings has used its scale to bring prices down very low in certain key areas, such as power-tools, to the extent that many small- and mid-sized independents have all but given up on these ranges.

As a result, one of the primary considerations for small retailers is not to achieve price leadership, but rather to achieve "price nullification". As much as possible, they want to remove price as a consideration.